UNIT 4 QUIZ REVIEW

QUIZ NOTES Capital market transactions involve any long-term debt or equity instrument. If a company sells stock to directly raise money for the firm, this is a primary market transaction, even if the company already has stock outstanding. A secondary market transaction is when the stock is transferred from one investor to another. Money market transactions can be denominated in any currency. They are merely very short-term, highly liquid securities. Nasdaq dealers and NYSE specialists hold inventories of stocks. Money markets are markets for Short-term debt securities such as Treasury bills and commercial paper.

QUESTION#1 If you decide to buy 100 shares of Google, you would probably do so by calling your broker and asking him or her to execute the trade for you. This would be defined as a secondary market transaction, not a primary market transaction. a. True b. False

Efficient Market Theory The semi-strong form efficient market only addresses publicly available information.  If an investor has inside knowledge, this would lead to an advantage and the ability to earn superior returns whereas in the strong form efficiency even with insider info – you cannot earn above average returns

Real risk-free rate of return.. r* If investors expect a zero rate of inflation, then the nominal rate of return on a very short-term U.S. Treasury bond should be equal to the real risk-free rate, r*.rT-bill = r* + IP

Question #2 Suppose 1-year T-bills currently yield 7.00% and the future inflation rate is expected to be constant at 3.20% per year. What is the real risk-free rate of return, r*? Disregard any cross-product terms, i.e., if averaging is required, use the arithmetic average. a. 3.80% b. 3.99% c. 4.19% d. 4.40% e. 4.62%

Risk free rate of return T-note yield = r* + IP 7%= r* + 3.20 7%-3.20%= r* 3.80= r*

Question #3 Suppose the real risk-free rate is 4.20%, the average expected future inflation rate is 3.10%, and a maturity risk premium of 0.10% per year to maturity applies, i.e., MRP = 0.10%(t), where t is the years to maturity, hence the pure expectations theory is NOT valid. What rate of return would you expect on a 4-year Treasury security? Disregard cross-product terms, i.e., if averaging is required, use the arithmetic average. a. 6.60% b. 6.95% c. 7.32% d. 7.70% e. 8.09%

Answer: Req’d Rate of return Real risk-free rate, r* 4.20% Inflation 3.10% MRP Years: 4 Per yearX 0.10%=0.40% Yield on t-year T-bond = r* + IPt + MRPt 4.20+3.10+4(.10)=7.70%

Risks Corporate and Treasury The differences across the corporate bonds is the default risk.  Bonds with lower credit ratings, moving from AAA-rated to BBB-rated, indicate the default risk of the company. 

Question #4 Which of the following factors would be most likely to lead to an increase in nominal interest rates? a. Households reduce their consumption and increase their savings. b. A new technology like the Internet has just been introduced, and it increases investment opportunities. c. There is a decrease in expected inflation. d. The economy falls into a recession. e. The Federal Reserve decides to try to stimulate the economy.

DRP Question Keys Corporation's 5-year bonds yield 6.20% and 5-year T-bonds yield 4.40%. The real risk-free rate is r* = 2.5%, the inflation premium for 5-year bonds is IP = 1.50%, the liquidity premium for Keys' bonds is LP = 0.5% versus zero for T-bonds, and the maturity risk premium for all bonds is found with the formula MRP = (t – 1) × 0.1%, where t = number of years to maturity. What is the default risk premium (DRP) on Keys' bonds? a. 1.17% b. 1.30% c. 1.43% d. 1.57% e. 1.73%

DRP Question Corp Yield: = Risk free rate 2.50% + Liq. Premium .50% + DRP Premium ? +Inflation Premium 1.50% MRP Premium= t-1(.01) 5-1(.01) .40% Corp Yield given is 6.20 So 6.20 minus 4.90=1.30 DRP

DRP Answer #5 Maturity 5 rKeys Yield 6.20% rT-bond Yield 4.40% r* Included in both bonds 2.50% IP Included in both bonds 1.50% MRP Included in both bonds (t − 1) × 0.1% 0.40% LP Included in Keys only 0.50% DRP Included in Keys only. Must find. rT-bond = r* + IP + MRP + DRP + LP rKeys = r* + IP + MRP + DRP + LP DRP = rKeys − r* − IP − MRP − LP = 1.30% Or, rKeys − rT-bond − LP = 1.30%

Quiz help last question If 10-year T-bonds have a yield of 5.2%, 10-year corporate bonds yield 7.5%, the maturity risk premium on all 10-year bonds is 1.1%, and corporate bonds have a 0.2% liquidity premium versus a zero liquidity premium for T-bonds,  what is the default risk premium on the corporate bond?

Quiz help last question Hint: T Bill rate =(Risk free rate + Inflation Premium) Corporate Yield = Risk free rate +Inflation Premium +DRP ? ?? +MRP 1.1% +Liq Premium .2% Corp Yield 7.5%